Current advice for financial advisers and planners.

SINCE THE BEAR MARKET IN STOCKS STARTED FOUR
years ago, hedge funds have become one of the hottest
investment vehicles, growing at a rate of 20% a year. The
hedge fund market is expected to increase to $1.5 trillion in
the next two to five years.

A HEDGE FUND IS A PRIVATE INVESTMENT CLUB,
usually a partnership, open to a small number of
wealthy investors, that invests in a variety of securities.
The name “hedge fund” is misleading since hedge funds do not
necessarily hedge.

A NEW BREED OF HEDGE FUNDS, called
funds of funds, allows investors to invest as little as
$25,000, compared with the previous typical minimum of
$250,000.

HEDGE FUNDS CAN BE HIGHLY LEVERAGED,
often using borrowed funds to acquire securities.
The degree of leverage should be considered as a risk factor
in judging the volatility of a fund’s performance.

IN LIGHT OF THE INCREASED VISIBILITY AND
IMPORTANCE of hedge funds and their vulnerability
to financial collapse, the SEC has issued new regulations
that require hedge fund managers to register with the
commission by 2006.

CPAs MAKING INVESTMENT RECOMMENDATIONS
to clients should consider how hedge funds differ
from mutual funds in terms of risk: There may be no
secondary market for investments in hedge funds, highly
leveraged funds can be especially volatile and some hedge
funds severely restrict withdrawals.

THOMAS G. EVANS, PhD, is professor of accounting
at the University of Central Florida School of Accounting in
Orlando. His e-mail address is tevans@bus.ucf.edu .
STAN ATKINSON, PhD, is a retired associate professor of
finance of the University of Central Florida. CHARLES H. CHO,
CPA, is a doctoral student in the School of Accounting at the
University of Central Florida. His e-mail address is ccho@bus.ucf.edu .

edge funds are one of the hottest investment
opportunities in today’s stock market. They have been very prominent
in the financial news, attracting a lot of attention from investors,
brokerage firms, the SEC and the attorney general of the state of New
York. To help CPAs who provide financial and investment advice to
clients, this article describes the nature of hedge funds and reviews
the latest news about them.

THE RISE AND FALL OF HEDGE FUNDS
Started in the late 1940s by Alfred W.
Jones, hedge funds have always attracted investors who wanted higher
returns than traditional mutual funds typically offer. Since the start
of the bear market in stocks four years ago, hedge funds have been
growing at a rate of 20% per year. A total of 8,500 such funds
controls $1.0 trillion, up from $400 billion five years ago and $100
billion 10 years ago; the hedge fund market is expected to increase to
$1.5 trillion in the next two to five years. (See “
What is a Hedge Fund? ” and “ Types of Hedge
Funds. ”)

Hedge funds started to become highly visible during the fall of 1998
with the near-collapse of the giant Long Term Capital Management LP
(LTCM) hedge fund. Eighty investors, including U.S. government
officials and top officers of some of the largest New York investment
and brokerage houses, contributed a minimum of $10 million each to
LTCM. Of its initial equity capital of nearly $1 billion, LTCM lost
about 90% in less than two months. The crisis threatened U.S.
financial markets and, in an unprecedented move to bail out private
investors, the Federal Reserve Bank of New York arranged a $3.63
billion rescue plan. Given such risks, CPAs should be aware that
investments in hedge funds should represent discretionary capital
reserved for speculative investments. Clients must be able to bear the
risks of these investments.

Investments in
Hedge Funds

Worldwide investment inflows for hedge funds reached
a record $106.6 billion for the first three quarters of
2004, more than the total for all of 2003.

The near-collapse of LTCM wasn’t an isolated instance; several other
large hedge funds have failed since 1998, and the rate of attrition in
hedge funds is now about 20% a year. This life cycle makes it more
difficult to find good long-term hedge fund investments, and means
that investors must carefully monitor market developments and quickly
respond to changes (see “ Long Term Capital
Management ”).

A recent development has made hedge funds available to potentially
less affluent investors: A new breed—the “funds of funds”—that allowed
investors to invest as little as $25,000, compared with the previous
typical minimum of $250,000, became popular in 2003. These vehicles
work like mutual funds, spreading investments across numerous hedge
funds. Funds of funds have become very popular with investors looking
for better returns; the number doubled to 1,600 in 2004 from 800 in
2000. There is no minimum net worth or income requirement to invest in
a fund of funds. (See “ To Hedge or Not to Hedge
.”)

What
is a Hedge Fund? A hedge
fund is a private investment club, usually a partnership open
to a small number of wealthy investors, that invests in a
variety of securities. The name “hedge fund” is misleading
since hedge funds do not necessarily hedge. Instead, they use
a combination of market philosophies and analytical techniques
to develop financial models that identify and evaluate market
opportunities. Very often, the financial models are very
sophisticated, highly quantitative and proprietary to the
fund. From the investor’s standpoint, the use of a single
investment strategy can limit diversification and increase
risk. Therefore, investment advisers should evaluate each
fund’s investment strategy and consider its suitability to
clients’ investment objectives.

Traditionally, hedge funds
have been off-limits for many mutual fund investors. Because
of the risks involved and to avoid regulation, they were
sold almost exclusively as unregistered securities only to
high-net-worth investors with at least $1 million in net
worth or more than $200,000 in annual income. However, the
recent rise in real estate values has made these thresholds
easier to reach than in the past.

Hedge funds differ
from mutual funds in many ways: They can buy a wider variety
of securities; they are restricted to fewer investors; they
can try to produce a gain irrespective of whether stock and
bond markets are rising or falling; they have not been
subject to strict SEC regulations and disclosure
requirements (except for the new “funds of funds” discussed
in the text of the article); they tend to concentrate their
portfolios in fewer investments; they have more leeway to
“time” the market; they cannot advertise; they can limit the
number of contributions and withdrawals; their compensation
method is based on incentive and management fees that
usually are much higher than those for mutual funds; and
they can invest in long, short and leveraged securities.

NEW SEC REGULATIONS In light of the heightened
visibility and importance of hedge funds and their vulnerability to
financial collapse due to their greater risk compared to mutual funds,
SEC Chairman William Donaldson expressed interest in improving the
regulation of hedge funds when he started his job, and the SEC has
begun to do that. However, it was New York State Attorney General
Eliot Spitzer who first focused the public’s attention on hedge funds
in September 2003, when he charged that the manager of Canary
Investment Management LLC had arranged with several mutual funds to
improperly trade their shares. Without admitting or denying
wrongdoing, the fund agreed to pay a $10 million fine and $30 million
in restitution, which caused Canary to fail. Shortly afterward, as
part of his investigation, Spitzer subpoenaed executives of a number
of hedge funds and mutual funds to provide information about mutual
fund trading. Within a month, a top trader at Millennium Partners LP,
a $4 billion hedge fund, admitted illegal late trading of mutual fund
shares. (Late trading occurs when investors receive a stock or fund’s
closing price, usually set at 4 p.m., for orders submitted as much as
several hours later.)

Types
of Hedge Funds Relative value (or “arbitrage”) funds
combine long positions in securities with
offsetting short positions to obtain returns that are
independent of market movements. For example, the portfolio of
a relative value fund might contain 30 undervalued (long) U.S.
pharmaceutical stocks and 30 overvalued (short) pharmaceutical
stocks. These funds attempt to limit market risk while earning
3% to 5% per year above the risk-free return on a three-month
U.S. Treasury bill.

Event-driven funds are long
positions that focus on specific corporate transactions,
such as mergers, acquisitions and tender offers. A fund of
this type may hold long positions in the stock of a company
that is a prime takeover target, hoping the acquirer will
pay a premium over the current market price.

Equity funds take long and short
positions in equity securities and focus on strong
turnaround companies with upward potential.

Global asset allocator (or “macro”) funds
are the most diverse and complex global
investments, combining stocks, futures, forward contracts,
options and commodities. A fund of this type might take a
long position in a currency that is undervalued and an
equal, short position in another currency that is
overvalued.

Short-selling funds trade in
securities or currencies they consider to be overpriced but
do not own, hoping to buy them back at lower prices and thus
to generate gains.

In early 2004 the SEC required brokerage firms to provide
information on how they help hedge funds recruit new investors and,
shortly thereafter, began investigating about 20 cases in which hedge
funds might have used insider information to profit from upcoming
private stock offerings. The SEC believed brokerage firms recruited
new investors for hedge funds from their clients (a technique known as
“capital introductions.”)

Also in 2004, in the state of New York, Spitzer filed criminal and
civil charges against a former trading executive at Canadian Imperial
Bank of Commerce, a major Canadian bank. He charged the bank’s
executive with telling hedge fund clients how they could disguise
their trading activities to avoid scrutiny for operating illegally.

Two earlier events, during the fall of 2003, had already tarnished
the image of hedge funds. The first was an FBI undercover operation in
New York to infiltrate foreign exchange and securities scams. The FBI
set up a fake hedge fund to collect evidence to break up an alleged
fraud ring. Separately, in an unprecedented move, the SEC took action
against a manager of an unregistered hedge fund, charging a “failure
to supervise.” This sent a signal even unregistered hedge funds were
subject to the same rules.

In July 2004 the SEC adopted a new regulation for hedge funds,
requiring registration with the commission by advisers who manage more
than $25 million of hedge fund assets for 15 or more clients (that is,
larger hedge funds), and establishing routine inspections by SEC
examiners. This regulation will become effective in 2006.

Currently about 60% of hedge fund managers have not voluntarily
registered with the SEC; they would have to register under the new
regulation. All hedge fund managers will be subject to regular SEC
inspections and examinations, allowing the SEC to collect basic
information about their activities. The new regulation also increases
the minimum net worth and net income requirements for investors—hedge
fund minimums have not been updated in several decades—to $750,000 in
annual income or net worth of $1.5 million.

The interesting confluence of hedge fund popularity and notoriety
has caused some to label the situation as the “hedge fund bubble” or
the “hedge fund conundrum.”

Long
Term Capital Management
T he financial crisis at Long Term Capital
Management vaulted hedge funds into the spotlight. LTCM was
created in March 1994 by former Salomon Brothers’ trader, John
Meriwether, who wanted to start an exclusive private
investment company. Meriwether put together a top-notch team
of physicists, mathematicians, computer experts and two
Nobel-Prize-winning economists, Robert C. Merton and Myron
Scholes. He marketed LTCM to high-income investors as a
market-neutral investment company that would deliver big
returns at low risk and achieve equity-like returns
independent of market swings. Eighty investors, including U.S.
government officials and top officers of some of the largest
New York investment and brokerage houses, contributed a
minimum of $10 million each.

Compensation. As in most hedge
funds, LTCM managers invested their own money in the fund;
they also earned fees and received performance incentives.
(Typically the management fees for hedge funds are double
the usual rate for mutual funds.)

Trading strategy. LTCM started as an
arbitrage fund but later became more of a global asset
allocator fund specializing in bond trading. As an arbitrage
fund, it had used sophisticated models to detect pricing
differences for securities or currencies in different
markets, offsetting long investments in one security with
short sales of another. Using mathematical models designed
to analyze fixed-income security markets and identify which
bonds were over- or under-priced in comparison with others,
it placed and hedged millions of dollars of bets on the
movement of bond prices.

LTCM tried to take
advantage of tiny movements in prices through “pool
trading,” that is, buying and selling $1 million blocks of
U.S. Treasury bonds, FNMAs or GNMAs. This strategy required
very large investments to generate profits often as small as
$500 per trade.

Initial success. Meriwether’s
company had instant and spectacular success. In its first
three years (1994–97), it almost doubled the original
investment of its owners. The firm earned returns of more
than 40% in 1995 and 1996; every $10 million invested in
1994 was worth $18.2 million in 1997. By August 1998,
though, markets began to move against its strategy. LTCM’s
historical models were ill-prepared for the Asian financial
crisis or the free fall in Russian bonds.

LTCM’s
excessive leverage compounded these losses: At its peak it
had contracts involving $160 billion worth of securities,
approximately 30 times its capital. Most hedge funds, by
contrast, leverage themselves at two times capital. By early
September 1998, LTCM had lost 50% of its $4.1 billion
capital and margin calls cascaded in. By the end of the
month, approximately 90% of the fund had been lost.

The rescue. On September 23, 1998,
the Federal Reserve Bank of New York arranged a $3.63
billion rescue package to stave off the possibility of
LTCM’s dumping its bond portfolio on already weakened
markets and thus aggravating the financial crisis. The
rescue used private-sector funds from 14 financial
institutions.

The moral. The near-collapse of LTCM
demonstrates that even with the combination of a highly
successful securities trader, huge capital base, experienced
money managers, highly intelligent and prominent investors
and sophisticated computer models, hedge funds can fail.

WHAT INVESTORS SHOULD KNOW Investors always are
looking for investments that offer greater returns than mutual funds
(see “Comparison of Hedge and Mutual Funds,” above). But investors
must recognize that hedge funds are riskier, may charge higher fees
and may have greater leverage than mutual funds. In light of the
increased risk, advisers and clients should thoroughly review the
fund’s offering documents and evaluate them against the investor’s
investment objectives, financial and tax situations. They should pay
particular attention to the compensation of the hedge fund management
and the fees and expenses. Multiple fees may be charged for investment
advice at a number of levels in the fund. For example, hedge fund
managers typically earn a share of fund profits as well as management
fees based on the value of the assets under management and fees for
security trades.

Hedge funds can be highly leveraged; that is, they often use
borrowed funds to acquire securities. The degree of leverage should be
considered as a risk factor, as it could cause volatile performance.
Although hedge funds represent only 4% of the stock market’s value,
they recently have accounted for nearly a quarter of daily trading
volume.

Comparison of Hedge and Mutual Funds

Characteristic

Hedge Fund

Mutual Fund

Expected returns

Higher

Lower

Risk of investment

Higher

Lower

Fees charged

Higher

Lower

Leverage

Higher

Lower

Trading volume

Higher

Lower

Secondary market

Limited

Widely available

Transfer
and withdrawal rules

Very restrictive

Not generally restrictive

There is no secondary market for some investments in hedge funds;
thus an investment may prove to be illiquid. Additionally, some hedge
funds severely restrict the transfer of interests or withdrawal of
funds. These aspects must be considered when investing in such funds.

Many of the risks associated with hedge funds are common to other
investments. Among these risks are

Political risk. When an investment is made in a
foreign nation and under the laws and sovereignty of that nation, the
risk is loss due to possible nationalization.

Transfer risk. This occurs when a foreign
government restricts the delivery of a foreign currency.

Settlement risk. A dispute between the parties
to a contract could prevent the fulfillment of the contract in
accordance with its stated terms.

Credit risk. This happens when the counter party
to a contract does not perform due to insolvency.

Legal risk. This occurs when the contract is
declared unenforceable due to legal problems.

Market risk. Market movements can cause losses.

Liquidity risk. This occurs when a market dries
up and it becomes impossible to liquidate a position.

CURRENT REGULATIONS Although hedge funds are
subject to a variety of laws, those with fewer than 100 accredited
investors are exempt from regulation under the Securities Act of 1933,
the Securities Exchange Act of 1934 and the Investment Company Act of
1940. (Accredited investors are defined in SEC regulation D, rule
501.) An individual must have at least $1 million in net worth and
more than $200,000 in income in order to invest in a hedge fund.
(These minimums are effective until the new ones go into effect in
2006.) If the hedge fund trades commodities, the manager must register
as a commodity pool operator with the Commodity Futures Trading
Commission. General hedge fund partners technically are not required
to register as investment advisers under the Investment Advisors Act
of 1940, but some do. A leveraged hedge fund may be subject to the
Federal Reserve’s regulation T, which specifies the amount of money a
brokerage fund can lend its clients to trade on margin.

Thoroughly review a hedge fund’s
offering documents and compare them with the
client’s investment objectives, financial
condition and tax situation before recommending
investment in such funds.

Make clients aware that, because a
majority of hedge funds today are not registered
(the SEC requirement takes effect in 2006), the
investment risk is even greater.

Explain to clients who are hedge fund
investors the importance of carefully monitoring
market developments and being able to quickly
respond to changes.

MAKE INFORMED DECISIONS As investors seek
higher returns, amounts invested in hedge funds are growing, making
such funds a popular investment vehicle. As hedge funds proliferate,
investors and their advisers need to be informed of the issues. CPAs
who provide financial and investment advice to clients must consider
the nature of hedge funds, how they work, the associated risks and the
latest financial developments to make informed decisions. The
financial risks are great and the lesson taught by the example of LTCM
is that even the most promising hedge fund can fail.

M ost CPA financial advisers are familiar with modern portfolio
theory (MPT) with respect to diversifying investments. Under MPT,
funds are invested among asset classes in a “long only” fashion to
achieve a targeted rate of return given a certain level of risk. In
addition to the “long” orientation, MPT usually involves being 100%
invested in various asset classes regardless of prevailing market
conditions.

The last few years have clearly demonstrated the risk (volatility)
of being fully invested in equities—even with a diversified
portfolio—over the short term. The old saying “You’re invested for the
long term” rang hollow when clients were looking for some defensive
action to protect their principal as the Nasdaq fell to nearly 1,100
from more than 5,000. Two of the main requirements for MPT to achieve
targeted rates of return are a lengthy time frame and investor
patience to stay the course.

The necessary time frame for allowing market cycles to run their
course for a “buy and hold, long only” equity investor is 15 plus
years. Funds with a time frame of less than five years are best
invested in a laddered bond portfolio or short term bond funds, with
only a minor equity allocation. The real challenge, therefore, is to
have an equity and bond strategy that can best achieve expected
returns during a 5-to-15-year time frame. For many investors, this
time frame requires a more dynamic investment approach (especially on
the equity side) and should incorporate some element of hedging or
risk management. Recovering from a 30% to 50% decline in equity values
to achieve a targeted 8% to 9% expected return is difficult to
accomplish during a relatively short 5-to-15-year time frame.

To assist our clients who wanted a degree of downside protection for
their equity holdings, during 2002, we employed a hedging strategy
using the ProFunds Ultra Bear Fund. Although not a hedge fund per se,
this no-load mutual fund utilizes leverage to seek investment results
that inversely correlate to 200% of the performance of the S&P
500. This allowed our clients to continue to hold (hedge) long
positions in their small- and mid-cap value funds, which we considered
to be of less risk. Our clients were appreciative of the fact we were
seeking to reduce volatility and achieve absolute returns instead of
merely accepting relative loss returns. For those clients who had
become concerned about the impact of rising interest rates on their
bond holdings, we utilized the Rydex Juno fund to hedge interest rate
risk. Rydex Juno seeks to inversely correlate to the price movement of
the 30-year Treasury bond by selling 30-year Treasuries at the end of
each day.

At this time we are not currently recommending specific hedge fund
managers to our clients, and we may never be truly comfortable with
the lack of transparency, limited liquidity, and risk to a specific
strategy inherent in individual hedge funds. However, we are beginning
to perform due diligence on “hedge funds of funds” offerings. These
funds provide a higher degree of liquidity and diversification than
any one specific hedging strategy. They typically invest in a variety
of strategies, such as arbitrage strategies (fixed income,
convertibles), event-driven strategies (mergers) and tactical
strategies (long/short). However, given the significant risks of hedge
funds (even a hedge fund of funds), we expect our overall allocation
to this asset class to be less than 10% of the equity component.

Ken A. Dodson, CPA, PFS, is a principal in King Dodson Armstrong
Financial Advisors Inc. of Columbus, Ohio, a member of the AICPA
Personal Financial Planning Executive Committee and the technical
editor of Prudent Investment Practices, a handbook for
investment fiduciaries. His e-mail address is kdodson@kda-financial.com
.

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